An analysis of the discriminant corporate failure prediction model based on stability of financial ratios

Abstract

The objectives of this study were to develop a discriminant model incorporating financial ratio stability that can be used to predict corporate failure, to identify critical financial ratios with significant predictive ability and to measure the improvement in the predictive ability achieved by incorporating a measure of stability of financial ratios to the discriminant failure model. The study, which covered the period between 1992 to 2000, was based on 20 companies; 10 failed and 10 non-failed. A failure prediction model that discriminates between failed and non-failed companies was developed using ratios alone and subsequently incorporating ratio stability using the standard deviation of the ratios. The findings show that it is possible to predict corporate failure with up to 70 percent accuracy three years before its occurrence, using ratio stability discriminant model. Further validation of the findings suggest that the predictive accuracy was significantly better than chance. Net profit/Sales, Net profit/Total Assets, Current Debt/Inventory, and Total Debt/Total Assets were identified as critical financial ratios in predicting corporate failure. In general the liquidity, profitability and leverage ratios were found to be significant in company failure prediction. The ability of a firm to meet both short-term and long-term obligations was a key indicator of a company's failure path.